Abstract

We develop a search and matching model where firms and workers are allowed to form matches (jobs) that can be formal or informal. Workers choose the level of schooling acquired before entering the labor market and whether searching for a job as unemployed or as self-employed. Firms post vacancies in each schooling market, decide the formality status of the job, and bargain with workers over wages. The resulting equilibrium size of the informal sector is an endogenous function of labor market parameters and institutions. We focus on an increasingly important institution: a "dual" social security system where contributory benefits in the formal sector coexist with non-contributory benefits in the informal sector. We estimate preferences for the system - together with all the other structural parameters of the labor market { using labor force survey data from Mexico and the time-staggered entry across municipalities of a non-contributory social program. Counterfactual experiments taking into account equilibrium effects show that changing the parameters of the dual social security system can increase output, schooling and long-term productivity at a small fiscal cost.